There are a number of reasons an investor would use options. These include speculation, hedging, spreading, and creating synthetic positions. There are other less common uses for options that won’t be discussed here.
Speculation is making a bet on the outcome of the future price of something. A speculator might think the price of a stock will go up, perhaps based on a gut feeling and hopes to make a short term profit by selling that stock at a higher price. Speculating in this way with a call option – instead of buying the stock outright – is attractive to some traders since options provide leverage. An out-of-the money call option may only cost a few dollars, compared the price of a $100 stock. It is this use of options that is part of the reason options have the reputation for being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen.
Options were invented not for speculation, but for the purpose of hedging. Hedging is a strategy that reduces risk at a reasonable cost. In this way, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. For short sellers, call options can be used in a similar way to restrict losses during a short squeeze, or in case of an incorrect short bet. (See also: Bill Ackman's Greatest Hits and Misses.)
Spreading is the use of two or more options positions. In effect, it combines having a market opinion (speculation) with limiting losses (hedging). Often times, spreading also limits potential upside as well, but these strategies can still be desirable since they are usually have a low implementation cost. Most spreads involving selling one option to buy another. Spreading is where the versatility of options is most apparent since a trader can construct a spread to profit from nearly any market outcome including markets that don’t move up or down. We will talk more about basic spreads later in this tutorial.
A special type of spread is known as a “synthetic.” The purpose of this strategy is to create a position that behaves exactly like some other position without actually controlling that other asset. For example, if you buy an at-the-money call and simultaneously sell a put with the same expiration and strike, you will have created a synthetic long position in the underlying asset. Why not just buy the underlying asset? Perhaps you are restricted for some legal or regulatory reason from owning it, but are allowed to create a synthetic position, or if the underlying asset is something like an index that is difficult to construct from its individual components.
Options Basics: How Options Work
TradingParticipate in options trading trading that is simpler, less expensive and easier to manage.
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